Guiding Disciplines During Heightened Uncertainty

By Scott Middleton, Scott Middleton, CFA, CIMA® | Principal and Director

“The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.”
— Warren Buffett

Uncertainty has gripped the global markets and economy in recent weeks. The personal and economic risks of COVID-19 were unforeseeable just a few months ago, and the range of potential outcomes from this crisis remain very wide. Our hearts go out to those whose health, employment, businesses, and families have been impacted by these recent events.

It is very difficult to anticipate how you will respond to risk. If you asked investors three months ago what they would think of a 30% market decline, most would have said: “I love bargains. I will buy stocks if that happens!” But it was easier to say it then than to have done so recently, because three months ago you probably could not envision your family’s health being in jeopardy or that the economic fallout could endanger your job security or your business.

Recent events have reminded us that no one can predict the future with certainty. Prudent investors acknowledge in the midst of adversity that matters very well may get worse. As financial writer Morgan Housel recently reminded investors, “Uncertainty shrinks your field of vision at the worst time. When the world changes in a 24-hour period it becomes hard to think more than 24 hours ahead.” It is ironic that long-term thinking becomes most powerful when everything around us is falling apart. The majority of long-term investment results are determined by decisions made during a small percentage of the time, and the first few months of 2020 have been one of those times. The results are usually tragic when long-term investors become short-sighted in the midst of a crisis. Selling assets once they have already fallen in value is the classic and most destructive aspect of having become short-sighted.

Another sign of investors losing their long-term focus is decision-making paralysis. Steep drops in the financial markets are often accompanied by the financial news going from bad to worse. The crisis has no end in sight. At such times investors can become strongly averse to rebalancing their portfolios and buying assets at depressed prices. This paralysis can be a sign of surrendering to the fears of being ridiculed (by oneself or others) and possibly suffering even greater financial losses in the near term.

For investors who have either sold after incurring significant losses or who have become paralyzed, the disingenuous solution can present itself as waiting to feel better about investing. The vast majority of investors think it is a good time to invest only after prices have risen for a time and have already experienced good upside momentum. However, waiting for better news means passing up the most attractive bargains and likely missing out the most powerful stock market gains. The results are significantly diminished long-term gains.

1. A long-term approach: History has proven that the most prudent way to invest is to maintain your focus on the long term. Inevitably volatile markets will test investors’ risk tolerance and patience. Taking a long-term approach allows investors to avoid the temptation to try to time the market and to instead focus on market fundamentals in order to generate the long-term returns.

2. Diversification: Our strategic asset allocation process is designed to weather all market environments through quantifying risk and diversifying among and within asset classes. The S&P 500 was down 14% in the fourth quarter of 2018. However, in calendar year 2019 the S&P 500 posted a gain of 31%. In all market environments, a prudent allocation to less-correlated asset classes help to reduce the volatility of returns over the long term.

3. Rebalancing your portfolio: We believe that periodic rebalancing during times of market dislocations is a key way to manage the long-term risk of your portfolio. What rebalancing means during stock market corrections and bear markets is trimming positions that have performed well, such as bonds, and adding to positions that have become cheaper in price, notably stocks. Portfolios that are not rebalanced will have their lowest exposure to growth assets at the bottom of the market, just as it begins to rebound. If markets turn down again after rebalancing, we rebalance portfolios again. Rebalancing has been a best practice for institutional investors for decades, and we are confident that rebalancing works well for all investors.

4. Tax management: For our taxable clients, we harvest losses to offset future realized gains. We sell investments trading at a loss and immediately replace that position with a similar asset in the same asset class to stay fully invested. Harvesting losses as they become available is an effective way to improve portfolios’ long-term tax efficiency.

5. Opportunities: During times when markets are hit hard, new investment opportunities are uncovered through rigorous due diligence. Creating an allocation to some of these areas may make sense for patient, long-term investors.

In summary, it might look bad today, and it might look bad tomorrow. But hang in there and embrace the disciplines that have endured over time.

We will get through this together.

Innovest strives to provide great service to our clients, especially during times of volatility. In the last several weeks, we’ve produced a number of materials to advise our clients as they deal with the repercussions of COVID-19. Our team is also working at full capacity and able to serve your needs. As always, we appreciate your continued confidence in Innovest, and please do not hesitate to reach out with any questions.